1 - 25 - 2020, 7 - 22 - 49 PM PDF

International Review of Finance, 11:3, 2011: pp.
269–301
DOI: 10.1111/j.1468-2443.2010.01113.x
The Impact of Liquidity Risk:

A Fresh Lookn
SEBASTIAN STANGEw AND CHRISTOPH KASERER
¼
w
The Boston Consulting Group, Munich, Germany and
¼
Head of the Department of Financial Management and Capital Markets,
Technische Universität München, Munich, Germany
ABSTRACT
This paper takes a fresh look at the importance of liquidity risk using a
comprehensive liquidity measure, weighted spread, in a Value-at-Risk (VaR)
framework. The weighted spread measure extracts liquidity costs by order size
from the limit order book. Using a unique, representative data set of 160
German stocks over 5.5 years, we show that liquidity risk is an important risk
component. Actually, liquidity risk is increasing the total price risk by over
25%, even at 10-day horizons and for liquid blue chip stocks and especially in
larger, yet realistic order sizes beyond h1 million. When correcting for liquidity
risk, it is commonly assumed that liquidity risk can be simply added to price
risk. Our empirical results show that this is not correct, as the correlation
between liquidity and price is non-perfect and total risk is thus overestimated.
I. INTRODUCTION
Liquidity as the ease of trading an asset has lately received considerable

attention in the academic world and in practice. From a risk management
perspective, liquidity risk is the potential loss due to the time-varying cost of
trading. Many risk management systems assume that a position can be bought
or sold without significant cost if the liquidation horizon is long enough.
Several authors have exemplary evidence that this myth might not hold true
in intraday settings. Francois-Heude and Van Wynendaele (2001) find a 2–21%
contribution of intraday liquidity impact in one stock over 4 months. Giot and
Grammig (2005) show that 30-minute intraday liquidity-adjusted Value-at-Risk
(VaR) is 11–30% for three large stocks over 3 months. In a 7-month sample of 60
stocks, Angelidis and Benos (2006) estimate that liquidity risk constitutes 11%
of the total intraday VaR in low capitalization stocks. Lei and Lai (2007) reveal a
n
We would like to thank Deutsche Börse AG for providing the ‘Xetra Liquidity Measure (XLM),’
weighted spread for the major German stock indices. We are grateful to Tobias Berg, the
participants of the Munich Finance Seminars and the German Finance Association Annual
Meeting 2009 for helpful comments. The usual caveats apply. Comments or questions are highly
welcome. An earlier version of this paper was available under the title ‘Why and How to Integrate
Liquidity Risk into a VaR-Framework’ on October 30, 2008.
r 2011 The Authors. Journal compilation r International Review of Finance Ltd. 2011. Published by Blackwell
Publishing Ltd., 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
International Review of Finance
30% total intraday risk contribution by liquidity in 41 small-price stocks over 12

months.
Further exemplary results show that liquidity risk might also be non-
significant in more illiquid markets. At daily horizon, Bangia et al. (1999) find
an underestimation of the total VaR by 25–30% in emerging market currencies
when looking at bid–ask spread liquidity. Le Saout (2002) estimates for 41 stocks
over 28 months that the bid–ask spread liquidity component can represent 50%
of the total daily risk for illiquid stocks.
However, is liquidity risk also significant when looking at standard 10-day
horizons and more perfect, liquid markets? Price risk increases the longer the
forecasting horizon; liquidity is a one-time cost independent of the horizon.
Thus, the liquidity risk component in total risk will be smaller for longer
horizons. As a consequence, the liquidity risk might be negligible in liquid stock
markets at standard horizons and neglect by risk frameworks could be justified.
In addition, can the assumption of insignificant liquidity risk be refuted on a
more representative basis beyond above small samples?
Above authors use different types of modeling approaches to introduce a
liquidity risk adjustment, each justified mainly by the type of data available.
What generally remains unjustified is the precise way of adjusting for liquidity.
Bangia et al. (1999) and Angelidis and Benos (2006) simply add liquidity risk to
price risk, implicitly assuming a perfect correlation between liquidity and
price.1 Berkowitz (2000), Cosandey (2001) and Francois-Heude and Van
Wynendaele (2001) assume zero correlation. So which assumption holds true?
This has been empirically untested so far.2
In this paper, we have a fresh look at those two questions on a representative
basis: Is liquidity risk significant in more liquid markets at standard horizons
beyond intraday and how should liquidity risk be integrated, does correlation
play a role?
Similar to Giot and Grammig (2005), we use weighted spread as the liquidity
measure. Weighted spread measures the liquidity cost of a specific order size as
the average spread in the limit order book weighted by individual limit order
sizes.3 It generalizes the approach of Bangia et al. (1999) beyond the quoted
spread and is a precise price-impact measure when immediately transacting
against the limit order book. While Giot and Grammig (2005) look at intraday
liquidity risk in a small sample, we analyze horizons beyond intraday on a
representative basis.
For our empirical analysis, we use – as far as we know – the most
representative sample of daily weighted spread available to academia. We
1 Giot and Gramming circumvent the problem of liquidity–price correlation by modeling

t-distributed net-returns, i.e. returns net of liquidity costs.
2 Critique brought forward by Francois-Heude and Van Wynendaele (2001), Angelidis and Benos
(2006), Loebnitz (2006), Lei and Lai (2007) and Jorion (2007).
3 This measure corresponds to the CRT by Irvine et al. (2000). Similar measures are used in other
contexts by Coppejans et al. (2001), Gomber and Schweickert (2002), Gomber et al. (2004) and
Domowitz et al. (2005).
r 2011 The Authors

270 Journal compilation r International Review of Finance Ltd. 2011
The Impact of Liquidity Risk
analyze a data set of the Xetra Liquidity Measure (XLM) for 160 stocks over 5.5
years. Usual samples are restricted to few stocks over few months, because
weighted spread has to be calculated manually from the whole intraday order
book, which is highly computational extensive. Our sample is available from
Deutsche Börse.
With the help of this sample, we empirically analyze the magnitude of
liquidity impact at standard, larger than intraday horizons. We also clarify
whether tail correlation between price and liquidity costs is perfect or not.
The remainder of the paper is organized as follows. Section II defines
liquidity, the liquidity measure and liquidity risk and discusses the situations
when our approach is valid. In Section III, we describe our empirical data set
and the empirical results. Section IV summarizes and concludes.
II. THEORETICAL FRAMEWORK AND ASSUMPTIONS
In Section II.A, we first define liquidity from a cost perspective, characterize the
situational assumptions in which our framework can be applied and describe
our empirical liquidity measure. In Section II.B, we introduce our risk
estimation approach as well as a risk decomposition to distill structural insights.
A. Liquidity cost framework

i. Definition of liquidity
To make the assumptions of our analysis explicit, we define liquidity as precise
as possible. We use a cost definition of liquidity, which takes a practical,
concrete investor’s perspective. We define illiquidity as the cost of trading an
asset relative to fair value (cp. Dowd 2001, p. 187ff.; Buhl 2004; Amihud and
Mendelson 2006). Fair value is assumed to be the mid-point of the bid–ask
spread. Extending from Amihud and Mendelson (2006), we distinguish three
components of the relative liquidity cost Lt(q) in percent of the mid-price4 for
an order quantity q at time t
Lt ðqÞ :¼ TðqÞ þ PIt ðqÞ þ Dt ðqÞ ð1Þ
where T(q) are direct trading costs, PIt(q) is the price impact versus mid-price
due to the size of the position and Dt(q) are delay costs if a position cannot be
traded immediately.
Direct trading costs T(q) include exchange fees, brokerage commissions and
transaction taxes.5 They will be neglected for further analysis as they are very
small and not relevant in a risk setting where time variation is of interest.6
4 Mid-price is the mid-point of the bid–ask spread.

5 Also called explicit or deterministic transaction costs, cp. Loebnitz (2006, p. 18f.).
6 On the Xetra system of the Deutsche Börse, for example, institutional traders pay only around
0.5 bp as transaction fee, cp. Deutsche Boerse (2008, p. 6ff.).
r 2011 The Authors

Journal compilation r International Review of Finance Ltd. 2011 271
Delay costs Dt(q) comprise costs for searching a counter party and the cost
imposed on the investor due to the bearing price risk and price-impact risk
during the execution delay.7 We assume that both forced and deliberate delays
are not relevant.
As we look at asset positions, which are continuously tradable during crises,
forced delay is not relevant. This means that no (or very few) zero trading days
occur in crises and the position size is not larger than the market depth.
Scanning our data, zero trading days appear to occur mainly in calmer market
periods, which, we hypothesize, happens because tumbling market prices
attract traders, which in turn ensures continuous trading.
We also assume that a deliberate, strategic delay has no significant benefit,
i.e. we assume that positions can be equally good when instantly liquidated
against the limit order book. This also neglects liquidation via limit instead of
market orders as well as up-floor or over-the-counter trading. So, we neglect any
(potential) effect of optimal trading strategies, which balance the increased
price risk of delay against the reduced liquidity cost by trading smaller
quantities (cp., e.g., Almgren and Chriss 1999, 2000; Almgren 2003; Bertsimas
and Lo 1998; and others). In our view, this is a reasonable assumption in four
cases. When we adopt the worst-case perspective of impatient traders, a
common risk assumption, potential benefits are consciously neglected. Benefits
are also non-existent if informational content of our trade is too high. The
trader wants to trade immediately on an informational advantage, which would
be revealed by trading more slowly or dissolve over time. Adverse informational
effects are also possible, i.e. trading more slowly could have price effects because
the market assumes informational advantage, which is not present in reality.8
Immediate liquidation is fair, too, if liquidity prices are efficient and a trader’s
risk aversion is greater or equal to that of the market.9 In this case, the marginal
gain from lower liquidity costs by delaying a transaction balances the marginal
loss due to higher price risk. Finally, optimal trading strategies might not be
feasible in times of market stress,10 because the optimization parameters are not
stable or strategic trading is not always possible.
As direct trading costs and delay costs are argued to be insignificant in our
analysis, we focus on price impact PIt(q) only, the difference between the
transaction price and the mid-price resulting from imperfectly elastic demand
and supply curves. For small volumes this is the bid–ask spread, but for larger
volumes the price impact is larger. Thus, if markets are fairly liquid, positions
are not too large and we adopt a worst-case perspective, the total liquidity cost
7 Almgren (2003) calls price impact risk ‘trading enhanced risk.’

8 Technically expressed as high permanent price impact rendering optimal trading strategies
useless.
9 If liquidity costs are too high, liquidity providers will enter with limit orders, because liquidity
costs, i.e. their profits, will compensate for the additional risk during the delay until the limit
order is executed. If liquidity costs are too low, market orders and withdrawn limit orders will
deplete the order book, because nobody is willing to take price risk during delay.
10 A point raised in Jarrow and Protter (2005, p. 9).
r 2011 The Authors

can be fairly measured with the price impact from immediate execution
(L(q)5PI(q)).
ii. The weighted spread liquidity measure

We have obtained our liquidity data from the Xetra system of the Frankfurt
Stock Exchange covering the bulk of stock transactions in Germany (cp.
Deutsche Boerse 2005). Xetra is an electronic trading platform by Deutsche
Börse, which is among the top 10 largest stock exchanges in the world. Trading
starts with an opening auction at 09:00 hours, is interrupted by an intraday
auction around 13:00 hours and ends with a closing auction finished at 17:00
hours. In between, trading is continuous. An electronic order book collects all
limit and market orders from market participants and matches them on price,
followed by time priority. The order book is anonymous, but visible to all
market participants. However, traders can also submit invisible, ‘iceberg’ orders
to trade large volumina, where traded volume is only revealed up to a certain
size and a similar order of equal size will be initiated once the first limit order is
transacted. For illiquid stocks, market makers post bid and ask quotes up to a
prespecified minimum quotation volume (cp. Deutsche Boerse 2004).
We measure price impact with the XLM. XLM is a weighted spread measure
that provides the liquidity cost of a round trip (CRT) of size q compared with its
fair value at the mid-price. The Xetra system automatically calculates XLM from
the visible and invisible part of the limit order book, i.e. including ‘iceberg’
orders. Mathematically, XLM is defined as follows. The weighted bid price bt(n)
for selling n number of shares is calculated as
P
bi;t ni;t
bt ðvÞ ¼ i ð2Þ
n
where bi,t and ni,t are the bid prices in h and bid volumes of individual limit
orders at time tP sorted by price priority. The individual limit order volume adds
up to n shares, i ni ¼ n. The weighted ask price is calculated analogously. XLM
is then calculated as the weighted spread in basis points (bp) for predefined
order sizes q
at ðnÞ bt ðnÞ
XLMðqÞ ¼ 100 ð3Þ
Pmid
where Pmid is the mid-price of the quoted (minimum) spread and q ¼ nPmid is
the size of the position measured in euro-mid-price value.
Graphically, XLM is the area between the bid and the ask curve in the limit
order book up to the order size q divided by the mid-price value (see Figure 1).
XLM calculates the price impact of an order of size q in basis points. It can also
be seen as the relative liquidity discount for a round trip of an order of size q.11
XLM is an ex-ante measure, because it calculates the cost from committed
liquidity in the order book – including hidden ‘iceberg orders’ – and neglects
any hidden liquidity (cp. Irvine et al. 2000, p. 4).
11 Gomber and Schweickert (2002) provide further theoretical background.
r 2011 The Authors

Price
= absolute liquidity cost = XLM(q) × q
a
P
b
q Order size
Quote depth / Size of next-best in €
Size of best limit orders bid limit order
Figure 1 XLM as the area between the limit order curves.

This figure shows a graphical representation of the order book; Pmid is the mid-price of
the bid–ask spread, a is the ask price, b is the bid price, q is the size of the position in h
mid-price value, XLM(q) is the weighted spread measuring ex-ante liquidity cost for a
round trip of size q.
Liquidity cost L(q) is then estimated from a transaction perspective. As a per-

transaction figure has much more practical meaning than a per-round-trip
figure, we assume that the order book is symmetrical on average.12 Therefore,
we can calculate the price impact per transaction under the situational
assumptions outlined in Section II.A.i as
XLMðqÞ
LðqÞ ¼ PIðqÞ ¼ : ð4Þ
2
In contrast to other price-impact proxies, measure (4) is a precise measure of
the ex-ante, order size differentiated liquidity cost at and beyond the bid–ask
spread depth.13 However, it is important to note that this liquidity cost measure
increases computational complexity because the price-impact curve must be
estimated, at least with a liquidity cost vector. In addition, concrete position
sizes must be interpolated between vector entries. Nevertheless, additional
computations are limited as long as weighted spread is provided by the
exchange, like in the case of XLM, and not calculated manually from the
intraday order book.
There are important similarities and differences between XLM and the
quoted bid–ask spread. The quoted spread is the simplest version of an ex-ante
liquidity measure, but is valid only up to the quoted depth. XLM is its natural
generalization, because it extends beyond best bid–ask prices to the rest of the
12 Liquidity cost estimation could gain further precision if exchanges would provide buy-side- and
sell-side-weighted half-spread data.
13 Up to now, it been empirically impossible to distill precise price impact measures for single
assets from ex-post transaction data (cp. Amihud 2002; Pastor and Stambaugh 2003).
r 2011 The Authors

order book. The bid–ask spread is the minimum weighted spread (for small
order sizes). However, spread is usually not measured for constant order sizes q,
because quoted depth differs between stocks. Spread also has upper bounds
regulated by the exchange protocol if there is market maker coverage.14 This is a
first indicator that liquidity-cost dynamics will be different when moving
beyond the minimum bid–ask spread.
B. Liquidity risk framework

i. Measurement approach
We want to calculate liquidity risk estimates as precise as possible. Therefore, we
use the historical, empirical distribution instead of a parametric approach to
estimate percentiles. This approach is possible due to our large sample and has
the advantage that we do not have to make any assumption regarding the
distribution of liquidity. This is important because liquidity distributions are
often far from normal.15 The development of a suitable parametrization
approach is left to future research.
To use percentiles of the historical distribution, we have to rely on the full
sample period, because short samples do not have enough observations to
finely estimate percentiles. We also deliberately accept that risk might be
different at different estimation periods. As a robustness test, we later look into
time variation in a parametric framework to test whether those drawbacks have
any significant impact (see Section III.D.ii).
Similarly, we measure risk ex-post and not ex-ante. This avoids any distortion
through a specific forecasting method, which is similarly a point left for future
development.
ii. Definition of risk measures

Before we turn to defining liquidity risk, we start with the definition of price
risk. We use standard risk statistics, against which we measure the impact of
liquidity risk.
Price and return are described in the usual framework of
Pmid;t ¼ Pmid;tDt expðrt;Dt Þ
where Pmid is defined as the mid-price Pmid;t ¼ at þb

2 with at and bt being the (best)
t
ask- and bid price at time t, respectively. rt;Dt is the Dt-period continuous mid-
price return at time t, i.e. rt;Dt ¼ lnðPmid;t =Pmid;tDt Þ . We adopt a traditional
approach from a VaR perspective and define price risk as the relative VaR at the
(1a)% confidence level over the horizon Dt
VaRa;Dt a
price ¼ 1 expðrt;Dt Þ ð5Þ
14 On Xetra illiquid stocks, defined by XLM and past volume, are covered by market makers. If the
stock is not covered, the bid–ask spread corresponds to the minimum spread in the order book.
15 Cp. Stange and Kaserer (2008) for a detailed discussion of the properties of XLM.
r 2011 The Authors

a
where rt;Dt is the a percentile of Dt-period return distribution. Consequently,
VaRprice measures the maximum percentage loss over the period Dt with a
confidence of (1a)%.
Analogously, we measure the total risk including the liquidity risk. To
calculate the impact of liquidity, we define the Dt-period net return in t as the
sum of the continuous mid-price return and the liquidity discount converted to
a continuous value

rnett;Dt ðqÞ ¼ rt;Dt þ lt ðqÞ ¼ ln Pmid;t =Pmid;tDt þ lnð1 Lt ðqÞÞ: ð6Þ

Note the difference of (6) to net-price returns, i.e. ln Pmid;t
ð1 Lt ðqÞÞ= Pmid;tDt ð1 LtDt ðqÞÞ Þ. Using net returns instead of net-price
returns, we implicitly assume that the liquidity cost of entering a position has
already been properly accounted for. While the quantified difference might not
be large, we believe that using net returns is conceptually closer to reality.
Price is then calculated as
Pnet;t ðqÞ ¼ Pmid;tDt expðrt;Dt þ lt ðqÞÞ ð7Þ
where Pnet;t ðqÞ is the achievable transaction price.
The Dt-period liquidity-adjusted total risk is then defined in a VaR framework as
the empirical a percentile of the net-return distribution.
VaRa;Dt a
total ðqÞ ¼ 1 expðrnett;Dt ðqÞÞ ð8Þ
VaRtotal is the maximum percentage loss due to mid-price risk and liquidation
cost over the period Dt with a confidence of (1a)%. This specification covers
the real dynamics of the net return on a certain stock position. It is practical but
also more general than existing approaches in the following ways:
1 We use a more precise liquidity measure than most papers by covering more
aspects of liquidity. Specifically, we account for the impact of order size on
liquidity. This extends the approach of Bangia et al. (1998, 1999), where
liquidity costs of any order size is proxied for with the bid–ask spread. As the
spread is valid only for very small order sizes, it is insufficient, which will be
demonstrated in the empirical section. The XLM measure is also more
precise than the ones used in Berkowitz (2000), Francois-Heude and Van
Wynendaele (2001) or Angelidis and Benos (2006), because it directly
measures liquidity costs in the limit order book instead of proxying for it.
2 As we take empirical percentiles instead of a parametric method, we avoid
any distributional assumption, especially on liquidity cost, such as in Giot
and Grammig (2005). Our approach will capture the non-normality of the
distribution as well, which is made possible by our large sample size. Figure 2
shows that the empirical net-return distributions can be far from normal.
3 Our approach takes percentiles of the net-return distribution and does not
treat price risk and liquidity separately. We look at the dynamics of net
returns that combines the mid-price-return dynamics and liquidity cost
dynamics. Instead of adding distribution percentiles of liquidity and price
risk separately, we acknowledge that liquidity cost and mid-price might not
r 2011 The Authors

Figure 2 Exemplary net-return histogram and fitted normal distribution for the
Comdirect stock in 2007.
This figure shows the exemplary histogram of net-return of the Comdirect stock for
trade-size of h100 thsd. and normal distribution based on its mean and variance in 2007.
be perfectly correlated. Although it is possible that large liquidity discounts

and low prices coincide, this must not be the case.
iii. Risk decomposition

To uncover the structure of the liquidity impact, we decompose total risk into
its components. We define relative liquidity impact l(q) as
VaRtotal ðqÞ VaRprice
lðqÞ ¼ : ð9Þ
VaRprice
l(q) is the maximum percentage loss due to the liquidity in relation to price risk.
It can be interpreted as the error made when ignoring liquidity. It is therefore a
measure of the relative significance of liquidity in the risk management context.
In addition, it can be used as a scaling factor with which price risk would need
to be adjusted in order to correctly account for liquidity. We measure it relative
to price risk, because absolute liquidity impact has little meaning by itself for
our type of analysis.
In order to uncover the effect of tail correlation between liquidity and price,
we define liquidity cost risk as the relative worst liquidity cost
VaRaliquidity ðqÞ ¼ 1 expðlat;Dt ðqÞÞ ð10Þ
r 2011 The Authors

with lat;Dt being the empirical percentile of the continuous liquidity discount.
This is the maximum percentage loss due to liquidity cost at a (1a)%
confidence level.
We can now apply a further decomposition of total risk and define the
correlation factor k(q) as a residual of
VaRtotal ðqÞ ¼ VaRprice þ VaRliquidity ðqÞ þ kðqÞ VaRliquidity ðqÞ: ð11Þ
Naturally, this is just a further decomposition of the liquidity impact
VaRliquidity
lðqÞ ¼ ð1 þ kðqÞÞ: ð12Þ
VaRprice
k(q) measures the tail correlation factor between mid-price return and liquidity
cost, the proportion of liquidity risk, that is diversified away due to tail
correlation. In this definition, the correlation factor is always non-positive,
k(q)0. If tail correlation is perfect, k(q) is zero and worst mid-prices and worst
liquidity costs can be added to get the total risk as is, for example, done in
Bangia et al. (1999). If there is some diversification between cost and price, k(q)
will become negative.
The liquidity impact l(q) contains the following conceptual components. First,
it contains the mean liquidity discount for the position of size q – in contrast to
other approaches. This is suitable as positions are usually valued at mid-prices
already neglecting mean liquidity costs. Second, it includes negative deviations
from the mean cost as measured by volatility and higher moments. Third,
possible diversification effects between price and liquidity are included and
liquidity risk is reduced. If liquidity cost and mid-prices have a less than perfect,
negative tail correlation (k(q)o0), a liquidity risk estimate based on the a
percentile of the liquidity cost distribution as in (10) will be incorrectly higher
than that when based on the net-return distribution as in (9).
iv. Interpretation of time horizon

The time horizon in the VaR framework is usually the time required to orderly
liquidate an asset. It is differentiated between asset classes but usually assumed
constant within one asset class such as stocks (cp., e.g., Jorion 2001, p. 24).
We would like to stress that in the framework presented above, the time
horizon Dt gets a more specific interpretation than usual. If we assume, for
example, a standard 10-day period (Dt510), the total risk measure (8) calculates
a 10-day risk forecast, which is the time required for the management to decide
and react. At day 10, the stock position will be instantly liquidated.
This interpretation is consistent with a general view on ‘orderly liquidation,’
where the time required comprises the management reaction time as well as the
liquidation time. It stands, however, in slight contrast to a more narrow view of
‘orderly liquidation’ that the time horizon of 10 days represents the period
during which a position is continuously liquidated.
Both interpretations are, however, valid in certain situations. In a situation
where very large positions can be liquidated without much time pressure, a
r 2011 The Authors

continuous liquidation over a certain time period is valid. This is also the
situation where optimal trading strategies can be applied to maximize the net
sales proceeds. In our framework, we are looking at a situation characterized in
II.A.i, which justifies instant liquidation. If we look at impatient traders or
equivalently at the worst case, we do not allow for mitigation of some of the
liquidity cost by allowing continuous liquidation. In such a case, ‘orderly
liquidation’ needs to be more generally defined and our approach is suitable.
III. EMPIRICAL RESULTS
In the empirical part, Section III.A describes our data set and Section III.B
provides some market background to our analysis. Section III.C presents our
empirical results and Section III.D includes our robustness tests.
A. Description of data
Our sample consists of 5.5 years of daily XLM data (July 2002–January 2008) for
all 160 stocks in the four major German stock indices (DAX, MDAX, SDAX andf
TecDAX).16 Therefore, in total, we cover a market capitalization of approxi-
mately h1.2 trillion (as of January 2008), which represents the largest part of the
market capitalization in Germany. As far as we know, this is the most
representative sample on weighted spread available to academia.
We received XLM data for all days, where a stock was included in one of the
four indices.17 Daily values are calculated by Xetra as the equal-weighted
average of all available by-minute data points.18 XLM(q) comprises for each day
the weighted spread for 10 standardized order sizes q. Standardized order size
reach from h25,000 to h5 million in the DAX and from h10,000 to h1 million in
all other indices. In addition to XLM data, we obtained the day-closing bid–ask
spread s at the Xetra trading system from Datastream.
Three stocks were excluded from the analysis due to missing XLM or
Datastream data.19 We also had to eliminate 408 XLM observations, where
liquidity data were available outside the standardized volume class structure
described above, to ensure that our estimates remain representative in each
16 The DAX contains the 30 largest publicly listed companies in Germany (by free-float market
volume), the MDAX includes the subsequent 70 largest before March 24, 2003 and 50 largest
thereafter and the SDAX includes the following 50 largest. The TecDAX, introduced during the
sample period on March 24, 2003, comprises the 30 largest technology stocks.
17 Therefore, our sample is non-constant containing 275 different stocks, but only 160 stocks at
one point in time.
18 This comprises a maximum of 1060 measurements during continuous trading.
19 Procon Multimedia (in SDAX between October 2002 and March 2003) and Medisana (in SDAX
between December 2002 and March 2003). Data could not be obtained for Sparks Networks (in
SDAX between June 2004 and December 2005), because it was not available in Datastream
anymore.
r 2011 The Authors

volume class.20 These exclusions left 99.9% or 323,670 of the stock days in the
sample.
In total, our remaining sample contains 1.8 million observations for the 1424
trading days. We divide our total sample into four sub-samples, each containing
the stocks of one index.
B. Market background
As background to our analysis, Table 1 summarizes market conditions during
the sample period. Markets were bullish in the largest part of the sample period.
We also captured the downturns in the second half of 2002 and the first month
of 2008. Because of beginning and end-of-period declines, the overall return
was rather average at 8% p.a. Naturally, market capitalization increased similar
to returns. Market capitalization is several times larger in the DAX than in all
other indices. MDAX contained the second largest average market capitaliza-
tion stocks, followed by TecDAX and SDAX. Volatility exhibited a similar, but
reversed pattern than returns. Because of the bullish period, our sample is
probably rather positively biased.
Daily transaction volume increased considerably during the sample period,
which is already a plausible indicator for improving liquidity. Transaction
volume was largest in the DAX; in the other indices it was several magnitudes
smaller. Contrary to the general positive trend, transaction volume in the
TecDAX remained steady after its initiation in 2003 and exhibits a level slightly
lower than the MDAX. SDAX transaction volume was again several times
smaller than that in MDAX or TecDAX. The high diversity in transaction
volumes underlines the representativeness of our sample.
C. Liquidity impact and its components

In this section, we analyze the significance of liquidity in standard risk measures
and its components. We will not discuss absolute risk levels in detail. The
interested reader will find estimates of absolute price risk and absolute total risk
in Appendix A.
i. Magnitude of liquidity impact

As a starting point, we look at the total impact of liquidity l(q) on risk in a
standard 10-day, 99% confidence-level VaR setting according to equation (9).
These parameters are typically used in a Basel II framework (cp. Dowd 2001,
p. 51). Table 2 presents statistics on the overall liquidity impact l(q) by order
size and index.
20 Less than 0.01% of all observations were available for connected periods of o7 days. We assume
that the automatic calculation routine of the Xetra computer was extended to non-standard
order sizes during trial periods.
r 2011 The Authors

Table 1 Market conditions during sample period
Market segment overview II/2002 2003 2004 2005 2006 2007 1/2008 Total perioda
Average continuous period return (%)b
r 2011 The Authors

DAX 52 24 6 27 20 22 15 6
MDAX 23 39 15 25 25 1 12 12
SDAX 36 35 11 28 29 4 14 10
TecDAX NA 52 3 26 24 32 25 23
Total 35 24 10 26 24 11 15 8
Average period return volatility (annualized) (%)c
DAX 64 41 22 19 23 25 51 30
MDAX 54 39 28 26 30 35 59 35
SDAX 65 47 35 31 36 38 58 40
TecDAX NA 54 42 31 38 44 71 42
Total 60 44 32 27 32 36 59 37
Average free-float market capitalization (in million euro)
DAX 15,217 14,615 17,983 20,350 24,357 29,949 29,325 21,008
MDAX 1043 1330 1940 2537 3734 3797 3121 2453
SDAX 106 235 320 393 500 775 640 418
TecDAX NA 725 863 898 995 1221 1204 955
Journal compilation r International Review of Finance Ltd. 2011

Total 3639 3483 4319 4998 6154 7379 7009 5160
Average daily transaction volume (in thsd. euro)
DAX 93,500 94,399 98,037 119,563 165,833 250,835 351,793 144,040

MDAX 1384 2297 4035 6242 11,034 18,243 22,351 7557
SDAX 36 160 237 514 958 2129 2081 780
TecDAX NA 1813 2345 2308 4769 7946 11,430 4052
Total 20,431 19,543 20,268 25,206 35,797 54,891 75,739 31,020
Table shows per-stock averages. All values equal weighted

a
Annualized.
b
Includes dividend returns, because price are adjusted for corporate capital actions.
c
pffiffiffiffiffiffiffiffiseries
ffi
Volatility has been annualized with 250.
281
Table 2 Liquidity impact on risk (VaR, 10-day, 99%)
282
l(q), VaR(10- Order size (in thsd. euro) Size
day, 99%) in % impact
of price risk Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
DAX
Mean (%) 1 NA 1 1 NA 1 NA 2 4 NA 9 16 21 24 26 10 0.78nnn
Median (%) 1 NA 1 1 NA 1 NA 1 3 NA 6 11 19 20 25 3 0.78nnn
Standard 1 NA 0 0 NA 1 NA 2 4 NA 8 14 16 16 18 14 0.84nnn
deviation (%)
Observations 42,129 NA 42,710 42,710 NA 42,710 NA 42,710 42,706 NA 42,663 41,71639,97038,22536,343 412,463
MDAX
Mean (%) 2 2 2 3 4 5 7 11 15 19 21 NA NA NA NA 8 0.58nnn
Median (%) 2 1 2 2 3 4 5 9 11 14 17 NA NA NA NA 4 0.62nnn
Standard 2 3 3 5 4 5 6 9 18 35 63 NA NA NA NA 22 0.62nnn
deviation (%)
Observations 69,578 74,779 74,574 73,930 73,291 72,671 71,357 68,520 60,784 53,461 46,741 NA NA NA NA 670,108
SDAX
Standard 52 8 11 16 20 29 44 48 17 15 34 NA NA NA NA 27 0.23n
deviation (%)
Observation 69,988 69,081 64,254 60,824 57,798 54,871 49,291 39,780 23,114 13,985 8,363 NA NA NA NA 441,361
TecDAX
deviation (%)
All
Mean (%) 4 NA 3 5 NA 7 NA 12 13 NA 17 NA NA NA NA 10 0.44nnn
Median (%) 2 NA 2 2 NA 3 NA 7 10 NA 13 NA NA NA NA 4 0.62nnn
Standard 30 NA 7 10 NA 16 NA 25 16 NA 42 NA NA NA NA 20 0.42nn
deviation (%)
Observations 217,436 NA 218,671214,590 NA 207,201 NA 184,968153,599 NA 113,798 NA NA NA NA 1,843,272
Table shows cross-sectional statistics of lambda, which is the impact of liquidity in percent of price risk according to equation (9); minimum column
measures risk at minimum spread level; all column is average over all standardized order sizes, i.e. without minimum; size impact is the coefficient of
log-size regressed on the log distribution statistic including an intercept.
n
10%, nn5% and nnn1% confidence level of being different from zero based on a two-tailed test.

r 2011 The Authors
On average, over all stocks and across all order sizes, total risk – including
liquidity risk – is 10% higher than price risk alone. DAX is generally the index
with the lowest liquidity risk, while MDAX and TecDAX are second. SDAX
consistently shows the highest liquidity impact levels across all order sizes. This
finding is consistent with trading volumes and market values discussed in
Section III.B.
There is significant variation in the liquidity impact between indices and
within indices as indicated by standard deviations. Variation is of the same
order of magnitude than the level. Impact is practically zero (1%) in small
order sizes of the DAX (oh250 thsd.). Liquidity impact can easily increases
above 20% in large stock positions of the DAX or medium stock positions in
small stocks. In an average h1 million SDAX positions, liquidity impact on risk
increases to 30% of price risk at a 10-day horizon.
Especially interesting is the liquidity impact calculated with spread as
revealed in the minimum column. This corresponds to the risk measurement
approach suggested by Bangia et al. (1999). Impact remains rather small across
all stocks and comparable to the liquidity impact measured with XLM(10) and
XLM(25), respectively. In SDAX and TecDAX, it is slightly higher than in the
smallest XLM bracket. Because median risk levels are comparable, this effect is
probably due to few outliers as XLM and spread data come from two different
databases.
Liquidity impact generally increases with order size.21 To analyze this size
effect more systematically, we separately estimated the impact of doubling
order size on l(q) in percent in the last column. To do so, we regress the log row
statistics on log order size including a constant intercept.22 Size impact is the
coefficient on log size and indicates the curvature of the price-impact function.
It specifically investigates into the importance of price-impact data in contrast
to spread data only and abstracts from the different levels in liquidity risk
between indices. Generally, the estimated price-impact statistic is positive but
smaller than one, which shows that the liquidity impact (risk) function is
concave.23 The price impact is larger in the DAX than in the other indices. Here,
the difference between small, liquid and larger less-liquid positions is especially
pronounced. With a size impact of 0.78, liquidity impact almost doubles in the
DAX when doubling order size. In the other indices, liquidity impact is already
large at small positions – hence the lower curvature. All size impacts are
statistically significant at the 1% level. The economically large size-impact
21 The decrease in the average SDAX position between h250 thsd. and h500 thsd. results from a
non-constant sample effect. Large SDAX positions were continuously tradable only in later
years. Therefore, risk estimates for large SDAX positions are calculated on a more liquid period
depressing liquidity impacts compared with more continuously traded small positions.
22 Ordinary least-squared regression equation is logðStatðqÞÞ ¼ c þ logðqÞ þ e, with stat being the
row statistic and c being a constant intercept.
23 This is consistent as already the price impact cost function is empirically found to be concave
(cp. Hasbrouck 1991; Hausman et al. 1992).
r 2011 The Authors

statistic underlines the importance of using order book information beyond the
spread for risk estimation – even in the DAX.
These results have important consequences for risk estimation techniques.
First, we find that liquidity is an important component in total risk, especially
in larger order sizes, where the price-impact estimation error relative to price
risk rises up to 30% at 10-day horizons. Second, estimating liquidity risk with
spread data is no valid alternative, as liquidity risk impact in this size class is
very small and increases considerably with size. Third, large variations indicate
that the constant scaling of price risk across all stocks, ‘hair cuts,’ are probably
insufficient and liquidity has to be accounted for specifically for each stock.
ii. Correlation effect

Next, we would like to specifically look into the tail correlation between mid-
price return and liquidity cost. A correlation factor k(q) of zero corresponds to
perfect tail correlation between liquidity and mid-price return. It mirrors the
case that liquidity costs are highest when prices are lowest. Table 3 shows the
results based on 10-day, 99% VaR according to (11). Mean correlation factors
range between 40% and 60% of liquidity risk. On average, 60% of the liquidity
cost risk is diversified away. The negative correlation factor reveals that large,
illiquid positions are relatively more liquid in crises. Stock market crashes
appear to attract liquidity, which allows to liquidate less-liquid positions more
cost-efficiently, however, at lower prices. Because over half of the liquidity risk is
diversified away, liquidity risk would be overestimated by about 100% at larger
sizes when neglecting correlation (cp. equation (12)).
Correlation factors are quite uniform across order sizes and indices at around
55% to 65%. Only in the DAX it is slightly lower at about 40%. Correlation
plays an even larger role at the spread level, where it is consistently higher than
that in larger order sizes. This underlines the different dynamics between the
spread, quoted by market makers, and weighted spread, which emerges from
free market competition. The cross-sectional standard deviation is also quite
constant. The size-independent nature is underlined by the statistically and
economically insignificant price-impact statistic.24
The k(q) statistic should be treated with care. The effect of correlation on
total risk is substantial only if the liquidity risk is also substantial (cp. equation
(12)). As liquidity risk is quite low at small positions, the overall error remains
small and the violation is less critical.
Overall, these empirical results refute the common assumption of a perfect
tail correlation, i.e. that it is reasonable to simply add up the price and the
liquidity risk. Doing so would overestimate the total risk, especially in large,
more illiquid order sizes. These results resolve the discussion as to whether the
perfect tail correlation assumption is valid or not. Our representative, empirical
results are in line with the argument of Francois-Heude and Van Wynendaele
(2001), who criticize the perfect correlation assumption of Bangia et al. (1999).
24 Estimated in a linear regression of the distribution statistic on size.
r 2011 The Authors

Table 3 Correlation factor (VaR, 10-day, 99%) by index and order size
k(q) VaR(10-day, Order size (in thsd. euro) Size
99%) in % of impact
r 2011 The Authors

liquidity risk Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
DAX
Mean (%) 64 NA 40 41 NA 43 NA 45 49 NA 34 41 40 40 41 41 0.00
Median (%) 68 NA 41 41 NA 41 NA 44 48 NA 49 47 42 41 41 44 0.00
Standard 21 NA 15 15 NA 16 NA 17 18 NA 87 47 30 24 19 36 0.00
deviation (%)
Observations 42,129 NA 42,710 42,710 NA 42,710 NA 42,710 42,706 NA 42,663 41,716 39,970 38,225 36,343 412,463
MDAX
Mean (%) 70 62 62 61 63 64 63 63 64 60 59 NA NA NA NA 62 0.00nn
Median (%) 72 66 66 62 63 67 64 61 62 63 60 NA NA NA NA 63 0.00nn
Standard 15 17 17 18 16 16 17 16 18 24 17 NA NA NA NA 18 0.00
deviation (%)
SDAX
Median (%) 68 61 65 65 65 66 64 59 56 61 57 NA NA NA NA 64 0.00nn
deviation (%)
TecDAX
Mean (%) 72 66 66 64 66 66 67 66 63 65 62 NA NA NA NA 65 0.00nn

Median (%) 73 66 66 66 70 66 67 69 65 63 65 NA NA NA NA 66 0.00n
deviation (%)
All
Mean (%) 68 NA 59 59 NA 61 NA 59 59 NA 50 NA NA NA NA 58 0.00nn
Median (%) 70 NA 61 61 NA 61 NA 58 58 NA 56 NA NA NA NA 60 0.00nn
deviation (%)
Observations 217,436 NA 218,671 214,590 NA 207,201 NA 184,968 153,599 NA 113,798 NA NA NA NA 1,843,272
Table shows cross-sectional statistics of the correlation factor, which measures correlation between liquidity cost and mid-price return according to (11); minimum column
measures the effect at minimum spread level; all column is average over all standardized order sizes, i.e. without minimum; size impact is the coefficient in 102 of size in a
linear regression of the distribution statistic on size including an intercept.
n
285
However, the overall effect of this assumption remains small if the liquidity
impact is small in total. It might also be different in other assets like currencies,
which were analyzed by Bangia et al. (1999), but we see no a priori reason why
this should be the case. We also hypothesize that correlation effects should be
similar for other liquidity cost measures, because they proxy for the same
phenomenon. Overall, our results indicate that tail correlation is important and
should be taken into account in illiquid stock positions.
iii. Liquidity impact at shorter horizons

Risk on a 10-day horizon calculated above provides a comparable reference to
the standard statistics usually requested by financial regulators. However, as
noted already in Section II.B.ii, when correctly and directly accounting for
liquidity risk, the 10-day horizon gets the notion of management reaction time
instead of liquidation time. In order to stick to the original intention behind
VaR, what a portfolio is worth in the worst case, we also calculate VaR at a 1-day
horizon. This statistic is also more comparable to the intraday results available
so far.
Table 4 shows the liquidity impact l(q) for a 1-day, 99% VaR according to
equation (9). As expected, the relative liquidity impact magnifies when
shortening horizons, because price risk is reduced while absolute liquidity risk
remains unchanged. The structure between indices remains unchanged. While
still being negligible in small DAX positions, total risk including liquidity is
almost double the price risk for large positions. Average h1 million SDAX
positions have a 490% liquidity risk impact. Even in some small positions,
liquidity plays a substantial role, with liquidity impact surpassing 10% in the
SDAX for small position sizes.
The size-impact statistic reveals a very similar curvature in magnitude in the
daily compared with the 10-day case. All size impacts are statistically significant
at the 1% level. Correlation effects are similar in structure but larger in
magnitude when compared with the 10-day horizon.25 Our results are
comparable to the 2–30% range found in other studies (cp. Francois-Heude
and Van Wynendaele 2001; Giot and Grammig 2005; Angelidis and Benos
2006).
D. Robustness tests
i. Effect of using the expected shortfall (ES) measure
Recently, literature has discussed coherent risk measures as an alternative to VaR
to overcome the shortfalls of VaR like non-sub-additivity (cp. Artzner et al.
1997; Acerbi and Scandolo 2007). This raises the question as to whether our
results would change significantly when switching to a different risk measure.
To test whether our results are robust or specific to the VaR, we calculate ES, also
called ‘conditional VaR’ or ‘expected tail loss,’ which is the expected loss in the
25 Results available on request.
r 2011 The Authors

Table 4 Liquidity impact on risk (VaR, 1-day, 99%)
l(q), VaR(1-day, Order size (in thsd. euro) Size
99%) in % of impact
price risk Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
DAX
r 2011 The Authors

deviation (%)
MDAX
deviation (%)
SDAX
deviation (%)
TecDAX

deviation (%)
Observation 35,741 37,133 37,133 37,126 37,075 36,949 36,299 33,958 26,995 20,641 16,031 NA NA NA NA 319,340
All
Standard 60 NA 23 31 NA 54 NA 65 50 NA 53 NA NA NA NA 52 0.22n
deviation (%)
Table shows cross-sectional statistics of lambda, which is the liquidity impact on risk in percent of price risk according to equation (9); minimum column
measures risk at minimum spread level; all column is average over all standardized order sizes, i.e. without minimum; size impact is the increase in risk in
percentage points when doubling order size, measured as coefficient in 102 of log-size in a regression of the log distribution statistic on log-size including an
intercept.
n
287
worst a% of the cases. We continue to use our basic approach detailed in Section
II.B.ii, but we replace VaR with ES defined as follows:
ESa;Dt ¼ Eðrjr < r a Þ: ð13Þ
When we calculate risk based on ES instead of VaR using a 10-day horizon

return and a 99% confidence interval of the empirical distribution, results are as
displayed in Table 5; effects of order size get accentuated. Generally speaking,
results are structurally similar when measuring risk as ES compared with VaR.
While total risk estimates increase, the impact of liquidity is comparable even in
the tail of the distribution. Our methodology and results are therefore quite
robust to a change in the ES risk measure.
ii. Effects of time variation

As a further robustness test, we calculate monthly, rolling estimates of l to
counter concerns that our results are due to the long estimation period. Rolling
total risk estimates are shown in Appendix A. This test also addresses any
concerns for non-constant-sample bias, because we calculate risk estimates only
on stocks included in the index due to data availability. Because empirical
percentiles cannot be calculated on monthly samples of daily data, we chose a
straightforward mean–variance estimation procedure. For each date, we
calculate the 20-day backward variance sr of continuous price return and
assume that the daily expected return is zero. The relative price risk on a 99%
confidence level is then defined as
VaR1%
price ¼ 1 expð2:33sr Þ: ð14Þ
Similarly, we calculated liquidity-adjusted total risk with the mean mrnet and
variance srnet of a 20-day backward net-return distribution
VaR1%
total ðqÞ ¼ 1 expðmrnet ðqÞ 2:33srnet ðqÞÞ ð15Þ
with net returns calculated according to equation (6). We then calculate the
liquidity impact l(q) according to equation (9). Neglect of negative skewness
and high kurtosis (fat tails) makes this procedure simple, but might under-
estimate risk. Because of the underestimation, absolute values need to be treated
with care, but are still – as lower bound – a suitable indicator for the time
variation of the liquidity impact on risk, especially if higher moments are fairly
constant.
Results for l(q) on the basis of a 10-day, 99% VaR according to (9) and (15) are
illustrated in Figure 3, details shown in Table 6. The impact of liquidity on risk
has generally declined over time across all indices. In all years, the liquidity
impact increased considerably with order size as the size-impact statistic reveals.
Our previous finding of the index rank (DAX, MDAX/TecDAX and SDAX) is
confirmed and stable over time. TecDAX, however, was shortly more liquid after
its initiation in 2003 until 2004. Although to be interpreted with care, the
liquidity impact probably remained non-negligible during the low-risk period
r 2011 The Authors

Table 5 Liquidity impact on risk (ES, 1-day, 99%)
l(q), ES(10-day, Order size (in thsd. euro) Size
99%) in % of impact
price risk Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
DAX
r 2011 The Authors

Mean (%) 1 NA 1 1 NA 1 NA 2 3 NA 12 17 22 23 26 9 0.82
deviation (%)
Observations 423 NA 431 431 NA 430 NA 427 412 NA 388 354 335 314 289 3811
MDAX
deviation (%)
Observation 780 826 812 803 791 774 724 653 550 425 376 NA NA NA NA 6734
SDAX
deviation (%)
Observations 608 564 499 431 397 370 319 234 154 98 55 NA NA NA NA 3121
TecDAX

deviation (%)
Observations 169 347 333 329 334 313 300 261 196 153 107 NA NA NA NA 2673
All
deviation (%)
Observations 1980 NA 2075 1994 NA 1887 NA 1575 1312 NA 926 NA NA NA NA 16,339
Table shows cross-sectional statistics of lambda, which is liquidity impact in percent of price risk according to equations (9) and (13); minimum column
measures risk at minimum spread level; all column is average over all standardized order sizes, i.e. without minimum; size impact is the coefficient in 102 of
log-size in a regression of the log distribution statistic on log-size including an intercept.
n
289
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
DAX 100
0%
2002 2003 2004 2005 2006 2007 2008
Figure 3 Liquidity impact on risk (rolling VaR, 10-day, 99%).

This figure shows mean l, which is liquidity impact in percent of price risk by sub-
sample calculated with a rolling mean–variance estimation of Value-at-Risk (10-day,
99%) according to (9) based on (15) for selected indices and volume classes.
from 2006 to 2007. The impact of liquidity on total risk was certainly
economically significant in the crises periods of 2002–2003 and in 2008.
Results for the whole panel (‘all’) have to be treated with care, because they
are distorted by the non-constant sample effect. Over the years, the liquidity of
less-liquid stocks improved considerably, which made their liquidity cost data
increasingly available. As consequence, less-liquid, high-cost stocks are
increasingly included in the sample, which increases the average risk estimate.
However, individual year estimates have almost no sample bias and underline
the fact that liquidity impact is economically significant.
If skewness and kurtosis would be included, these findings are also likely to
get confirmed, as the one-time liquidity cost deduction will probably introduce
additional skewness, which keeps the relation between price and liquidity risk
valid. Overall, this confirms the fact that liquidity price impact is economically
significant enough to encourage integration into risk measurement systems.
iii. Effects of portfolio diversification

We have shown that liquidity risk is economically significant when looking at
individual stocks in the different indices. But does this result persist when
looking at portfolios of stocks? If diversification between mid-prices of different
stocks is larger than that between liquidity of different stocks, the liquidity
impact might be reduced substantially.
To test the robustness of our results against the effects of portfolio diversi-
fication, we calculated daily value-weighted index returns and determined the
r 2011 The Authors

Table 6 Liquidity impact on risk (rolling VaR, 10-day, 99%)
Avg. l(q), Order size (in thsd. euro) Size
VaR(10-day, impact
99%) in % Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
of price risk (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%)
r 2011 The Authors

DAX
2002 1 NA 1 1 NA 1 NA 2 4 NA 10 18 17 17 18 8 0.77
2003 1 NA 1 1 NA 1 NA 2 4 NA 9 19 23 25 25 10 0.82nnn
2004 1 NA 1 1 NA 1 NA 1 2 NA 8 15 21 25 29 10 0.83nnn
2005 1 NA 1 1 NA 1 NA 1 2 NA 3 7 11 14 19 6 0.70nnn
2006 0 NA 0 1 NA 1 NA 1 2 NA 3 5 7 10 14 4 0.65nnn
2007 0 NA 0 0 NA 1 NA 1 1 NA 2 4 5 7 9 3 0.60nnn
2008 0 NA 0 0 NA 0 NA 1 1 NA 2 3 5 7 8 3 0.63nnn
All 1 NA 1 1 NA 1 NA 1 2 NA 5 10 13 16 18 6 0.74nnn
D2002–2008a 1 NA 0 0 NA 0 NA 1 1 NA 4 8 4 2 0 1
MDAX
2002 4 6 7 8 10 12 16 19 28 31 30 NA NA NA NA 12 0.42nnn
2003 3 3 4 5 7 10 16 24 35 40 37 NA NA NA NA 14 0.63nnn
2004 2 2 3 4 5 6 11 18 32 35 37 NA NA NA NA 13 0.73nnn
2005 2 2 2 3 3 4 6 10 21 29 34 NA NA NA NA 10 0.74nnn
2006 1 1 1 2 2 3 4 6 12 17 22 NA NA NA NA 7 0.71nnn

2007 1 1 1 2 2 2 3 4 8 12 17 NA NA NA NA 5 0.65nnn
2008 1 1 1 1 1 2 2 3 6 10 13 NA NA NA NA 4 0.67nnn
All 2 2 3 3 4 6 8 12 20 24 26 NA NA NA NA 10 0.61nnn
D2002–2008a 2 3 4 4 5 6 7 7 8 6 4 NA NA NA NA 2
SDAX
2002 13 12 27 61 91 120 153 115 79 NA NA NA NA NA NA 36 0.56nn
2003 10 12 17 26 36 42 40 41 40 51 64 NA NA NA NA 27 0.32nnn
2004 6 7 11 20 27 35 40 52 46 38 120 NA NA NA NA 24 0.49nnn
2005 6 5 7 11 15 19 24 29 32 41 37 NA NA NA NA 17 0.46nnn
2006 3 4 5 7 10 13 19 28 37 36 37 NA NA NA NA 15 0.56nnn
2007 2 2 3 4 5 7 10 17 31 38 43 NA NA NA NA 13 0.71nnn
2008 2 2 2 3 5 6 10 16 26 32 39 NA NA NA NA 10 0.75nnn
All 6 6 9 14 17 21 23 28 34 38 43 NA NA NA NA 18 0.42nnn
291
D20022008a 7 6 18 47 74 99 130 86 45 13 21 NA NA NA NA 18
292
Table 6 (continued)
Avg. l(q), Order size (in thsd. euro) Size
VaR(10-day, impact
99%) in % Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
of price risk (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%)
TecDAX
2002 NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA
2003 2 3 4 5 8 11 15 21 25 28 31 NA NA NA NA 11 0.57nnn
2004 2 3 4 5 8 12 18 26 26 29 31 NA NA NA NA 13 0.60nnn
2005 2 2 3 5 6 8 11 17 27 38 41 NA NA NA NA 12 0.67nnn
2006 2 2 2 3 4 5 7 13 22 27 31 NA NA NA NA 10 0.68nnn
2007 1 1 2 2 3 4 5 8 15 19 23 NA NA NA NA 8 0.66nnn
2008 1 1 1 2 2 3 4 6 11 15 16 NA NA NA NA 5 0.65nnn
All 2 2 3 4 6 8 11 16 22 27 29 NA NA NA NA 11 0.62nnn
D2002–2008a 0 1 1 1 2 4 4 5 3 1 1 NA NA NA NA 1
All
2002 6 NA 8 10 NA 13 NA 12 14 NA 15 NA NA NA NA 13 0.14nnn
All 3 NA 4 6 NA 9 NA 14 17 NA 20 NA NA NA NA 11 0.45nnn
D2002–2008a 3 NA 4 4 NA 4 NA 2 3 NA 5 NA NA NA NA 2
Table shows mean lambda, which is liquidity impact in percent of price risk by sub-sample calculated with a rolling mean-variance estimation of
Value-at-Risk (10-day, 99%) according to (9) based on (15). Minimum column measures risk at minimum spread level; all column is average over
all standardized order sizes, i.e. without minimum; size impact is the coefficient in 102 of log-size in a regression of the log distribution statistic
on log-size including an intercept.
a
Statistic shows absolute change between 2003 and 2008 when 2002 number not available.
n

r 2011 The Authors
liquidity impact l(q) based on a 10-day, 99% VaR according to (9). While our
methodology does not use optimized position weights, a value-weighted
portfolio should show effects of diversification if there are any. Results are
presented in Table 7. Estimates demonstrate that the liquidity impact on the
portfolio level is of a similar magnitude as that on the average individual stock
level (cp. Table 2). Especially in larger sizes, liquidity impact is increased at the
portfolio level, for example, it increases to 54% for the h1 million position in
the SDAX portfolio compared with 30% for the average individual stock
position. This must be driven by larger liquidity commonality in larger sizes, i.e.
diversification in liquidity between stocks decreases with larger sizes. Even for
the all-stock portfolio, liquidity impact levels are higher than for the average
stock. Overall, our results are robust to diversification effects in stock portfolios.
IV. CONCLUSION AND OUTLOOK
In this paper, we modeled liquidity risk based on the weighted spread liquidity
measure in a VaR framework. The main advantage over existing approaches is
the higher precision of the weighted spread, which calculates liquidity cost
differentiated by order size, i.e. the price impact, from the limit order book.
We argued that weighted spread is a valid liquidity measure from a risk
perspective in a wide range of situations, which we defined clearly. If we look at
limit order book markets, where this type of data is available and from the
perspective of institutional investors, for whom other direct trading costs are
negligible, two situational assumptions are critical.
First, our approach works most precise for continuously tradable asset
positions, for example, for small- to medium-sized positions in developed stock
markets. Positions cannot be too large, like block holdings, and markets have to
be fairly liquid with few zero trading days. If this is not the case, forced
execution delay can incur costs that we have neglected.
Second, we assume that deliberate, strategic delay has no significant benefit,
which renders optimal trading strategies useless. This is a fair assumption in
four possible cases. We can adopt a worst-case perspective, for example, because
external restrictions require to close whole positions immediately. Any possible
benefit from delay is then consciously ignored. From a risk perspective, strategic
delay also remains with unrealizable benefit if the optimal trading strategy is
non-stable in crises situations and can therefore not provide any benefit on an
expected basis. Further, if liquidity prices are efficient in fairly liquid markets,
strategic delay has per definition no marginal benefit. Finally, optimal trading
strategies are also useless if the real or perceived (i.e. adverse) informational
content of the trade is high and delay only increases the probability of adverse
price movements.
This discussion shows that these cases cover a variety of situations. Overall,
our approach is most valid for up to medium-sized positions in generally
continuously trading markets.
r 2011 The Authors

294
Table 7 Liquidity impact l(q) (VaR, 10-day, 99%) by (index) portfolio and order size
l(q) VaR(10-day, Order size (in thsd. euro) Size
99%) in % of impact
liquidity risk Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
DAX
Estimate (%) 1 NA 1 1 NA 1 NA 1 2 NA 12 22 18 25 27 10 0.84nnn
MDAX
Estimate (%) 2 2 2 2 3 5 9 5 13 21 20 NA NA NA NA 7 0.60nnn
SDAX
Estimate (%) 5 32 15 27 32 52 56 26 39 45 54 NA NA NA NA 35 0.16n
TecDAX
Estimate (%) 1 1 2 2 3 4 5 8 13 15 17 NA NA NA NA 6 0.61nnn
All stocks
Estimate (%) 3 NA 2 2 NA 3 NA 4 5 NA 20 NA NA NA NA 6 0.55nn
Table shows portfolio statistics of lambda, which is the impact of liquidity in percent of price risk according to (9); minimum column measures risk at minimum spread
level; all column is average over all standardized order sizes, i.e. without minimum; size impact is the coefficient of log-size regressed on the log distribution statistic
including an intercept.
n

r 2011 The Authors
We then defined liquidity-adjusted VaR of a specific position in a

straightforward manner based on net return, i.e. mid-price return less the
weighted spread of the position. This definition avoids any distortion through
correlation assumptions between liquidity and price return, which we analyzed
separately.
Empirically, we find that the impact of liquidity relative to price risk is small
at small order sizes, especially at the spread level (o10% for 10-day, 99% VaR).
However, it increases to 20–30% of price risk in larger sizes in illiquid indices as
well as in the DAX. Results aggravate if we switch to daily VaR horizons.
We also took a detailed look at tail correlation between liquidity and mid-
price returns and showed that it is non-negligible. Liquidity risk would be
overestimated by 100% if correlations are ignored. In the cases we identified
above, where liquidity risk is an economically significant component of total
risk, total risk will be severely overestimated if liquidity cost risk is simply added
to existing risk measures. Therefore, several common approaches should be
adapted to avoid this distortion.
We find that results are structurally similar when using ES instead of VaR risk
measures. Our results are therefore transferable. To check the time robustness of
these findings, we use a monthly, rolling mean–variance estimation method.
Results are confirmed. Results are also similar for portfolios of stocks, when
portfolio diversification is accounted for.
Overall, we strongly advocate the use of weighted spread data such as XLM to
improve risk estimates. Liquidity constitutes a large part of total risk, especially
in larger positions and at short horizons – even in more liquid market segments.
Several venues are still open for future research. Because we have used
empirical ex-post risk measurement to avoid any distortion by a specific choice
of parametrization or forecasting, appropriate techniques will need to be
selected. It will also be helpful to test the precision of our estimates against real
transaction data. Future research can also address two assumptions to extend
this approach to a larger realm of situations and assets. The empirical
integration of delay risk is still unsolved as is the empirical questions when
liquidity prices are efficient. Further insights into when and under which
circumstances delay occurs will also help to advance this line of thinking.
Another simplifying advance would be a method that directly integrates the
liquidity–price correlation in a parametric approach when adding liquidity to
price risk. Tackling these research areas will help to further advance the
integration of liquidity into risk measurement.
Dr. Sebastian Stange

The Boston Consulting Group
Ludwigstr. 21
80539 Munich, Germany
Sebastian.Stange@web.de
r 2011 The Authors

REFERENCES
Acerbi, C., and G. Scandolo (2007), Liquidity Risk Theory and Coherent Measures of
Risk. Working Paper. Available at SSRN: http://ssrn.com/abstract=1048322.
Almgren, R., and N. Chriss (1999), ‘Value under Liquidation’, Risk, 12, 61–3.
Almgren, R., and N. Chriss (2000), ‘Optimal Execution of Portfolio Transactions’,
Journal of Risk, 3, 5–39.
Almgren, R. F. (2003), ‘Optimal Execution with Nonlinear Impact Functions and
Trading-Enhanced Risk’, Applied Mathematical Finance, 10, 1–18.
Amihud, Y. (2002), ‘Illiquidity and Stock Returns: Cross-Section and Time-Series
Effects’, Journal of Financial Markets, 5, 31–56.
Amihud, Y., and H. Mendelson (2006), ‘Stock and Bond Liquidity and its Effect on
Prices and Financial Policies’, Financial Markets and Portfolio Management, 20, 19–32.
Angelidis, T., and A. Benos (2006), ‘Liquidity Adjusted Value-at-Risk Based on the
Components of the Bid-Ask Spread’, Applied Financial Economics, 16, 835–51.
Artzner, P., F. Delbaen, J.-M. Eber, and D. Heath (1997), ‘Thinking Coherently’, Risk,
10, 68–71.
Bangia, A., F. X. Diebold, T. Schuermann, and J. D. Stroughair (1998), Modeling
Liquidity Risk With Implications for Traditional Market Risk Measurement and
Management. Working Paper No. 6, Financial Institutions Center at The Wharton
School.
Bangia, A., F. X. Diebold, T. Schuermann, and J. D. Stroughair (1999), ‘Liquidity on the
Ouside’, Risk, 12, 68–73.
Berkowitz, J. (2000), ‘Breaking the Silence’, Risk, 13, 105–8.
Bertsimas, D., and A. W. Lo (1998), ‘Optimal Control of Execution Costs’, Journal of
Financial Markets, 1, 1–50.
Buhl, C. (2004), Liquidität im Risikomanagement. PhD Thesis, University of St. Gallen.
Coppejans, M. T., I. H. Domowitz, and A. Madhavan (2001), Liquidity in an Automated
Auction. Working Paper. Available at SSRN: http://ssrn.com/abstract=295765.
Cosandey, D. (2001), ‘Adjusting Value at Risk for Market Liquidity’, Risk Magazine,
October 115–8.
Deutsche Boerse (2004), Xetra Release 7.1, Marktmodell Aktien. Technical Report
Deutsche Boerse (2005), Orderbuchstatistik (order book statistics xetra close-1.xls).
Available at http://www.deutsche-boerse.de
Deutsche Boerse (2008), Preisverzeichnis für die Nutzung der Handels-EDV der
Frankfurter Wertpapierbörse. Available at http://www.deutsche-boerse.de
Domowitz, I., O. Hansch, and X. Wang (2005), ‘Liquidity Commonality and Return
Co-Movement’, Journal of Financial Markets, 8, 351–76.
Dowd, K. (2001), Beyond Value at Risk – The New Science of Risk Management. Hoboken,
NJ: Wiley & Sons.
Francois-Heude, A., and P. Van Wynendaele (2001), Integrating Liquidity Risk in a
Parametric Intraday VaR Framework. Working Paper. 7th Belgian Financial Research
Forum, Liège.
Giot, P., and J. Grammig (2005), ‘How Large is Liquidity Risk in an Automated Auction
Market?’, Empirical Economics, 30, 867–87.
Gomber, P., and U. Schweickert (2002), ‘Der Market Impact: Liquiditätsma im
elektronischen Wertpapierhandel’, Die Bank, 7, 485–9.
Gomber, P., U. Schweickert, and E. Theissen (2004), Zooming in on Liquidity. Working
Paper. Available at SSRN: http://ssrn.com/abstract=559406.
Hasbrouck, J. (1991), ‘Measuring the Information Content of Stock Trades’, The Journal
of Finance, 46, 179–207.
Hausman, J. A., A. W. Lo, and A. C. MacKinlay (1992), ‘An Ordered Probit Analysis of
Transaction Stock Prices’, Journal of Financial Economics, 31, 319–79.
r 2011 The Authors

Irvine, P. J., G. J. Benston, and E. Kandel (2000), Liquidity Beyond the Inside Spread:
Measuring and Using Information in the Limit Order Book. Working paper.
Available at http://ssrn.com/paper=229959
Jarrow, R., and P. Protter (2005), Liquidity Risk and Risk Measure Computation.
Working paper, Cornell University. Available at http://people.orie.cornell.edu/
~protter/WebPapers/riskmeasliq6.pdf.
Jorion, P. (2001), Value at Risk: The New Benchmark for Managing Financial Risk, 2nd edn.
New York: McGraw-Hill, New York.
Jorion, P. (2007), Value at Risk: The Benchmark for Controlling Market Risk, 3rd edn.
McGraw-Hill Publishing Co.
Le Saout, E. (2002), Incorporating Liquidity Risk in VaR Models. Working Paper.
Available at: http://www.scribd.com/doc/7174003/Incorporating-Liquidity-Risk-in-
VaR-Models#stats.
Lei, C. C., and R. N. Lai (2007), The Role of Liquidity in Value at Risk – The Case of
Hong Kong. Working Paper. Available at SSRN: http://ssrn.com/abstract=1009578.
Loebnitz, K. (2006), Market Liquidity Risk: Elusive no more – Defining and quantifying
market liquidity risk. Diploma Thesis, University of Twente.
Pastor, L., and R. F. Stambaugh (2003), ‘Liquidity Risk and Expected Stock Returns’,
Journal of Political Economy, 111, 642–85.
Stange, S., and C. Kaserer (2008), The Impact of Order Size on Stock Liquidity – A
Representative Study. CEFS Working Paper 2008 No. 9. Available at http://ssrn.com/
abstract=1292304
APPENDIX A
Table A1 Price risk (VaR, 10-day, 99%)

Index Mean (%) Median (%) Standard deviation (%) Observations
DAX 16.3 14.7 4.4 43,767

MDAX 17.2 15.8 8.1 76,750
SDAX 19.5 17.7 7.3 72,373
TecDAX 24.3 22.6 9.2 38,070
All 18.9 17.4 7.9 230,960
This table contains distribution statistics on price risk calculated as 10-day, 99% VaR according to
equation (5).
Table A2 Price risk (VaR, 1-day, 99%)

Index Mean (%) Median (%) Standard deviations (%) Observations
DAX 5.6 5.5 1.1 43,710

MDAX 6.1 5.7 2.2 71,458
SDAX 7.2 6.5 3.0 72,313
TecDAX 8.2 7.9 1.8 36,801
All 6.7 6.0 2.5 224,282
This table contains distribution statistics on price risk calculated as 1-day, 99% VaR according to
equation (5).
r 2011 The Authors

298
Table A3 Absolute liquidity-adjusted total risk (VaR, 10-day, 99%)
Total risk, VaR(10-day, Order size (in thsd. euro) Size
99%) abs., liquidity- impact
adjusted in % Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
DAX
Standard deviation (%) 4 NA 5 5 NA 5 NA 5 5 NA 5 8 7 7 8 6 0.11nnn
MDAX
Standard deviation (%) 8 9 9 9 9 9 9 9 10 10 11 NA NA NA NA 9 0.03nn
SDAX
Standard deviation (%) 8 7 7 8 9 9 9 10 9 10 16 NA NA NA NA 9 0.12nnn
Observations 70,048 69,081 64,254 60,824 57,798 54,871 49,291 39,780 23,114 13,985 8363 NA NA NA NA 441,361
TecDAX
All
Standard deviation (%) 8 NA 8 8 NA 9 NA 9 9 NA 11 NA NA NA NA 9 0.08nnn
This tables shows cross-sectional statistics on empirical, absolute total risk including a liquidity adjustment according to equation (8); minimum column
percentage points when doubling order size, measured as coefficient in 102 of log-size in a regression of the distribution statistic on log-size including an
intercept.
n

r 2011 The Authors
Table A4 Absolute liquidity-adjusted total risk (VaR, 1-day, 99%)
Total risk, VaR(1-day, Order size (in thsd. euro) Size
99%) abs., liquidity- impact
adjusted in % Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
r 2011 The Authors

DAX
Standard deviation (%) 1 NA 1 1 NA 1 NA 1 1 NA 2 5 4 4 4 3 0.30nnn
MDAX
SDAX
TecDAX

All
Standard deviation (%) 4 NA 3 3 NA 5 NA 6 5 NA 7 NA NA NA NA 5 0.24nnn
This tables shows cross-sectional statistics on empirical, absolute total risk including a liquidity adjustment according to equation (8); minimum column
percentage points when doubling order size, measured as coefficient in 102 of log-size in a regression of the distribution statistic on log-size including an
intercept.
n
299
Table A5 Liquidity-adjusted total risk on 10 day horizon (rolling estimate, VaR, 10-day, 99%)
300
L-adj. VaR Order size (in thsd. euro) Size
(10-day, impact
99%) in % Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
(%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%)
DAX
2002 24 NA 24 24 NA 24 NA 24 25 NA 26 28 29 30 31 26 1.32nnn
2003 16 NA 17 17 NA 17 NA 17 17 NA 18 20 21 21 22 18 0.94nnn
2004 9 NA 9 9 NA 9 NA 10 10 NA 10 11 12 12 13 10 0.70nnn
2005 8 NA 8 8 NA 8 NA 8 8 NA 8 9 9 9 10 9 0.29nnn
2006 9 NA 9 9 NA 9 NA 10 10 NA 10 10 10 10 11 10 0.29nnn
2007 10 NA 10 10 NA 10 NA 10 10 NA 10 11 11 11 11 11 0.22nnn
2008 16 NA 15 15 NA 15 NA 15 15 NA 15 15 16 16 16 15 0.18nn
All 12 NA 12 12 NA 12 NA 12 12 NA 13 13 13 14 14 13 0.37nnn
D2002–2008a 12 NA 12 12 NA 12 NA 12 13 NA 14 15 16 16 17 14 0.96
MDAX
2002 21 21 21 22 22 23 24 26 28 27 27 NA NA NA NA 23 1.69nnn
2003 16 16 16 16 16 16 17 19 21 23 24 NA NA NA NA 17 1.87nnn
2004 11 12 12 12 12 12 13 13 16 17 19 NA NA NA NA 13 1.46nnn
2005 11 11 11 11 11 11 11 11 13 14 15 NA NA NA NA 12 0.80nnn
2006 12 12 12 12 12 12 13 13 13 14 15 NA NA NA NA 13 0.59nnn
2007 13 13 13 13 13 13 14 14 14 15 15 NA NA NA NA 14 0.49nnn
2008 20 19 19 20 20 20 20 20 20 21 22 NA NA NA NA 20 0.50nnn
All 14 14 14 14 14 14 14 15 16 16 17 NA NA NA NA 15 0.65nnn
D2002–2008a 7 7 7 8 8 8 9 11 13 11 10 NA NA NA NA 8 1.12
SDAX
2002 24 23 27 35 41 47 47 32 4 NA NA NA NA NA NA 28 1.45
2003 19 19 20 21 23 25 28 31 35 28 29 NA NA NA NA 22 2.98nnn
2004 14 15 15 16 18 20 21 25 31 31 33 NA NA NA NA 18 4.49nnn
2005 13 13 13 13 14 15 16 18 24 27 30 NA NA NA NA 15 3.83nnn
2006 14 14 14 15 15 15 16 18 23 27 31 NA NA NA NA 17 3.53nnn
2007 15 15 15 15 15 16 16 17 20 23 26 NA NA NA NA 17 2.22nnn
2008 20 22 22 22 21 21 22 24 28 33 35 NA NA NA NA 23 2.80nnn
All 16 16 16 16 17 17 18 20 23 25 28 NA NA NA NA 18 2.59nnn

r 2011 The Authors
D2002–2008a 8 7 11 18 24 29 28 13 19 3 1 NA NA NA NA 11 3.95
Table A5 (continued)
L-adj. VaR Order size (in thsd. euro) Size
(10-day, impact
99%) in % Minimum 10 25 50 75 100 150 250 500 750 1000 2000 3000 4000 5000 All
(%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%)
r 2011 The Authors

TecDAX
2002 NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA
2003 21 21 21 22 22 23 24 25 27 29 28 NA NA NA NA 23 1.87nnn
2004 17 17 17 17 17 18 19 20 22 24 25 NA NA NA NA 18 1.86nnn
2005 13 13 13 13 13 14 14 15 17 20 21 NA NA NA NA 15 1.76nnn
2006 15 15 15 15 15 15 16 16 18 20 23 NA NA NA NA 16 1.49nnn
2007 16 16 16 16 16 16 17 17 18 20 21 NA NA NA NA 17 1.03nnn
2008 24 23 23 23 23 23 23 24 26 26 29 NA NA NA NA 24 1.11nnn
All 16 16 16 16 17 17 17 18 20 21 23 NA NA NA NA 18 1.45nnn
D2002–2008a 5 5 5 5 5 6 6 7 8 7 6 NA NA NA NA 5 0.54
All
2004 13 NA 13 14 NA 15 NA 15 16 NA 15 NA NA NA NA 15 0.61nn

All 14 NA 14 15 NA 15 NA 16 16 NA 17 NA NA NA NA 15 0.72nnn
D2002–2008a 8 NA 8 9 NA 9 NA 9 10 NA 9 NA NA NA NA 9 0.30
Table shows liquidity-adjusted total risk by sub-sample according to equation (9) calculated with a rolling mean-variance estimation. Minimum
column measures risk at minimum spread level; all column is average over all standardized order sizes, i.e. without minimum; size impact is the
coefficient in 102 of log-size in a regression of the distribution statistic on log-size including an intercept.
a
Statistic shows absolute change between 2003 and 2008 when 2002 number not available.
n
301

1 - 25 - 2020, 7 - 22 - 49 PM PDF

Încărcat de

Informații document

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

1 - 25 - 2020, 7 - 22 - 49 PM PDF

Încărcat de

Drepturi de autor:

Formate disponibile

International Review of Finance, 11:3, 2011: pp.

The Impact of Liquidity Risk:

Liquidity as the ease of trading an asset has lately received considerable

30% total intraday risk contribution by liquidity in 41 small-price stocks over 12

1 Giot and Gramming circumvent the problem of liquidity–price correlation by modeling

r 2011 The Authors

II. THEORETICAL FRAMEWORK AND ASSUMPTIONS

A. Liquidity cost framework

4 Mid-price is the mid-point of the bid–ask spread.

r 2011 The Authors

7 Almgren (2003) calls price impact risk ‘trading enhanced risk.’

r 2011 The Authors

ii. The weighted spread liquidity measure

11 Gomber and Schweickert (2002) provide further theoretical background.

r 2011 The Authors

Figure 1 XLM as the area between the limit order curves.

Liquidity cost L(q) is then estimated from a transaction perspective. As a per-

r 2011 The Authors

B. Liquidity risk framework

ii. Definition of risk measures

where Pmid is defined as the mid-price Pmid;t ¼ at þb

r 2011 The Authors

r 2011 The Authors

be perfectly correlated. Although it is possible that large liquidity discounts

iii. Risk decomposition

r 2011 The Authors

iv. Interpretation of time horizon

r 2011 The Authors

III. EMPIRICAL RESULTS

r 2011 The Authors

C. Liquidity impact and its components

i. Magnitude of liquidity impact

r 2011 The Authors

Average continuous period return (%)b

r 2011 The Authors

Journal compilation r International Review of Finance Ltd. 2011

DAX 93,500 94,399 98,037 119,563 165,833 250,835 351,793 144,040

Table shows per-stock averages. All values equal weighted

Journal compilation r International Review of Finance Ltd. 2011

r 2011 The Authors

ii. Correlation effect

24 Estimated in a linear regression of the distribution statistic on size.

r 2011 The Authors

r 2011 The Authors

Journal compilation r International Review of Finance Ltd. 2011

iii. Liquidity impact at shorter horizons

25 Results available on request.

r 2011 The Authors

r 2011 The Authors

Journal compilation r International Review of Finance Ltd. 2011

When we calculate risk based on ES instead of VaR using a 10-day horizon

ii. Effects of time variation

r 2011 The Authors

r 2011 The Authors

Journal compilation r International Review of Finance Ltd. 2011

Figure 3 Liquidity impact on risk (rolling VaR, 10-day, 99%).

iii. Effects of portfolio diversification

r 2011 The Authors

r 2011 The Authors

Journal compilation r International Review of Finance Ltd. 2011

Journal compilation r International Review of Finance Ltd. 2011

IV. CONCLUSION AND OUTLOOK

r 2011 The Authors